Will Yelp's Business Model Get it in Trouble?

Jacob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Yelp (NYSE: YELP) is a website that allows people to review local businesses. Interestingly enough, the company also engages in the advertisement business, and there is no way of telling what happens when the two lines of business clash. On the internet, there are many business owners complaining that Yelp actually works like a "mafia" that collects money from small businesses in return for "protection" against negative reviews.

Is Yelp the modern mafia?

The whole argument centers around Yelp's "filter" function. Yelp claims that its software automatically filters reviews it suspects to be fake. On the other hand, some business owners claim that the positive reviews regarding their businesses started being "filtered" mysteriously once they rejected to pay Yelp for its advertisement services. Because the filtered reviews are not included in the average rating score of businesses, they suffered a drop in their average scores after refusing to pay Yelp. This is a very serious claim, and it actually resulted in a class action lawsuit against Yelp. The claim of the lawsuit was that Yelp's entire business model is similar to old school mafias that used to collect money from local businesses to "protect them" from "bad things" that might happen to them.

Some companies will have as many as 93 reviews, out of which 85 are "filtered" and only 8 are shown and included in the calculation of the average score for the establishment. This sounds highly fishy to me--if Yelp believes that most of the reviews on its website are fake, then this marks the failure of its business model as a whole.

The morality of the story is also hard to swallow. Yelp doesn't tell how it separates "genuine" reviews from "fake" reviews. It says it uses a "secret algorithm" to decide on which reviews are correct and which ones are fake. If the company has no way to prove that certain reviews are fake, removing them might cause discomfort to many small businesses who could suffer the consequences. Imagine a local restaurant with a small number of reviews when a few of their positive reviews are filtered out because Yelp's algorithms think that those reviews are fake? This would drop the restaurant's average score greatly.

Current Lawsuits and Complaints

There are currently several lawsuits going on regarding Yelp's business model. One such lawsuit was initiated by nine original companies and joined by a couple other companies. The complaint that was filed at the district court of California claim that the company engages in extortion, attempted extortion, intentional interference with prospective business advantage and violations of the unfair competition law. The amended complaint can be viewed by clicking here.

In 2011, a U.S.district judge dismissed a case against Yelp, saying that there wasn't enough solid evidence to prove that Yelp was extorting small business owners to pay it for positive reviews. In 2013, the case is being brought in the court once again. A San Diego judge is quoted as saying that Yelp's business model resembles "the modern-day version of the mafia going to stores and saying, You want to not be bothered?” This is a very serious accusation and can result in very painful consequences for Yelp's business.

When one searches "Yelp extortion" on Google, the search engine finds thousands of stories. When this many small businesses across the country are complaining about the same thing, something might be going on. In addition, there are currently more than 700 FTC complaints against Yelp, and the list is ever-growing.

Yelp is Expensive Anyways

Even without the legal issues going on, Yelp is overvalued and there is no justification to its $2-billion market value. Last year, Yelp generated $137 million in revenues and a loss of $19 million. Yelp hasn't posted a profit in years, and its margins are still in the negative zone. Also, keep in mind that the company continues to issue more shares in order to pay its employees. In 2011, the company had 59 million shares outstanding--today it has 63 million shares. This is not sustainable at all.

Google is a huge threat to Yelp

Besides, Google (NASDAQ: GOOG) is moving towards the local advertisement market, and it has the capability to end Yelp's growth once and for all. Currently, users can search a local business and review it using Google Maps, and as more people notice this it is likely to hurt Yelp's business model. Google has a tendency to dominate everywhere it goes, and the company enjoys a huge footprint across the world. Google might not be the only company that is entering in this market either. Apple (NASDAQ: AAPL) has been investing a lot of money and acquiring a large number of mapping-related businesses, and it may launch its own Yelp-like service soon. Up until now, Yelp had almost no competition and it couldn't capitalize this, now that it will have serious competition, things will get even tougher for the company.

Google and Apple may be better bets 

I am sure Google and Apple will do a much better job of monetizing local business reviews without making it look like a mafia business. Besides, both companies have much, much better valuations than Yelp could even dream of. Google trades for 24 times future earnings, and Apple trades for 7 times future earnings (excluding cash). Growth might have slowed down for these two companies but at least they are making money. With few exceptions here and there, investors are much better off by putting their money into companies that actually earn money. Yelp reminds me of companies in the dot.com bubble of 1999. 

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Jacob Steinberg owns shares of Apple. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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